Money/Credit/Debt
Dear Client, I will be meeting clients in Europe next week. Instead of our usual weekly bulletin, I will be sending you a Special Report discussing how “The Most Important Trend In The World” – a trend that has been around for thousands of years and accounts for all of the economic growth the world has ever experienced – has recently reversed, and what this means for your investment decisions. This is one report you will not want to miss. Best regards, Peter Berezin, Chief Global Strategist Highlights China’s debt problem is a symptom of a deeper ailment: The country’s excessively high saving rate. While the authorities are taking steps to boost consumption, this is likely to be a drawn-out process. In the meantime, the economy will have to continue recycling savings into fixed-asset investment. Now that credit growth has fallen close to nominal GDP growth, the need to further suppress credit growth has abated. The 6-month credit impulse is already moving higher, and the 12-month impulse should follow suit by the middle of the year. As Chinese growth bottoms out this summer, global growth will start to reaccelerate. This will help boost global cyclical stocks as well as EM shares. Feature Global Growth Worries Weigh On Risk Sentiment Global growth is clearly slowing (Chart 1). Our tactical MacroQuant model, which did an exemplary job of flagging the Q4 selloff in stocks, is flashing amber again, after having turned more constructive in late December (Chart 2). Chart 1Growth Is Slowing As we discussed last week, the world economy should stabilize by mid-year, paving the way for global equities to rise further from current levels.1 Until then, volatility will remain elevated. Many factors will influence the trajectory of global growth over next 12 months, but perhaps none more important than what happens to China. In this week’s report, we focus on one of the most critical problems facing the Chinese economy – a problem that surprisingly gets very little attention from market participants. China’s Savings Problem Saving is usually considered a virtue. At the individual level, that is certainly true. However, at the economy-wide level, saving can be a vice if it leads to a shortfall of spending, resulting in higher unemployment. This is precisely the problem that China confronts today. Simply put, the country consumes too little of what it produces. The result is a national saving rate of 45% of GDP, higher than any other major economy in the world (Chart 3). Chart 3China Saves A Lot The reasons for China’s high saving rate are long and varied. Just as the Great Depression instilled a sense of thrift among Americans who came of age in the 1930s, memories of the abject poverty that many older Chinese citizens endured during the Cultural Revolution have restrained the desire to spend needlessly. While the younger generation is more willing to live it up, it also faces severe constraints to spending more. The labor market remains challenging, even for those with a university degree. Sky-high property prices require young people to save a large fraction of their incomes in order to have any hope of owning a home. Looking out, there is little reason to expect China’s saving rate to fall rapidly. While the number of people entering retirement is steadily increasing, the share of the population in their prime savings years – ages 30-to-59 – has yet to peak (Chart 4). Chart 4China: Share Of Population In Its High Savings Years Has Yet To Peak In addition, an increasingly skewed male-female sex ratio has created an "arms race" of sorts among Chinese bachelors hoping to accumulate enough wealth to find a bride. One academic study concluded that this factor accounts for half of the increase in the household saving rate since the late-1970s.2 Unfortunately, China’s gender imbalance is only likely to worsen, given that the ratio of men between the ages of 25-and-39 and women between the ages of 20-and-34 – a proxy for gender imbalances in the marriage market – is projected to rise from 1.06 in 2011 to 1.34 by the middle of the next decade (Chart 5). Chart 5Not Enough Chinese Brides What To Do With Excess Savings? By definition, a country’s savings are either recycled into domestic investment or exported abroad via a current account surplus. The latter strategy served China well in the years leading up to the Great Recession, when the country’s current account surplus reached a whopping 10% of GDP (Chart 6). Just like Germany today, China was able to export its excess production with the help of a highly undervalued currency. Chart 6China: No Longer Exporting Savings Abroad Unfortunately for China, as its economy has grown in relation to the rest of the world, running massive trade surpluses has become more difficult. This is especially true today, when the country is being singled out by the Trump administration and much of the international community for alleged unfair trade practices. As China’s ability to churn out large current account surpluses declined, the government moved to Plan B: propping up growth by recycling the country’s copious savings into fixed-asset investment (see Box 1). This process saw households park their savings in banks and other financial institutions which, in turn, lent the money out to companies and local governments in order to finance various investment projects. Not surprisingly, debt levels exploded (Chart 7). Chart 7China: From Exporting Savings To Investing Domestically (And Building Up Debt) This strategy was feasible when China did not have a lot of debt and needed more factories, housing, and public infrastructure. But those days are long gone. The rate of return on assets among state-owned enterprises has now fallen below their borrowing costs (Chart 8). Our EM team estimates that 15%-to-20% of apartments in China are sitting vacant.3 Chart 8Rate Of Return On Assets Below Borrowing Costs For Chinese SOEs How To Boost Consumption There is only one long-term solution to China’s excess savings problem: Tackle it head-on by taking steps to increase consumption. The good news is that there is some scope to do so. The Chinese income tax structure is fairly regressive. Poor households face an effective income tax rate exceeding 40%. This is well above OECD norms (Chart 9). A more progressive tax system would boost spending among poorer households. It would also curb inequality, which has increased sharply since the 1980s (Chart 10). The saving rate among the richest 10% of Chinese earners is close to 50%. Policies that shift income from the rich to the poor would reduce overall household savings. Chart 10China: Inequality Has Risen In The Past Two Decades As a share of GDP, public-sector spending in China on education, health care, and pensions is close to half of the OECD average (Chart 11). If the government were to finance the increase in social spending by running larger budget deficits, this would help reduce overall national savings both by increasing the budget deficit and by discouraging precautionary household savings. Unlike in most countries, the poor in China are net savers, largely because they cannot rely on a publicly-funded social safety net (Chart 12). Recent tax changes, including an increase in the threshold at which income begins to be taxed and an expansion of deductions for childhood education, medical costs, and home loan interest and rent, are steps in the right direction. More Financial Repression? Over a longer-term horizon, the Chinese authorities are also likely to step up efforts to discourage savings by driving down real interest rates into negative territory. Since nominal interest rates are already low in China, the only way to reduce real rates is to raise inflation. The added benefit of higher inflation is that it would boost nominal GDP growth, thus putting downward pressure on the debt-to-GDP ratio. The catch is that negative real rates could destabilize the currency, fueling capital outflows. Negative real rates could also inflate asset bubbles, especially in the property market. The only way to square the circle is to tighten administrative controls, such as those relating to property speculation and capital flows, in order to preserve the benefits of negative real rates, while attenuating the costs. This suggests that hopes that the RMB will become an international reserve currency anytime soon are likely to be dashed. China Will Continue To Back Off From Its Deleveraging Campaign Realistically, the measures to boost consumption listed above will take time to implement. In the meantime, China’s economy continues to slow. Not only does a weaker economy endanger domestic stability, it also puts the Chinese government in a weaker negotiating position with the Trump administration over trade matters. This suggests that the government will continue to ease off its deleveraging campaign at least until growth recovers. Granted, one could have said the same thing last year. That is correct, but here is the thing: last year, credit growth was running at a much faster pace than today. Total social financing increased by only 11% year-over-year in December, not much higher than trend nominal GDP growth. On all three occasions over the past ten years when credit growth has fallen back towards nominal GDP growth, the government has allowed credit growth to accelerate (Chart 13). Chart 13China: Credit Growth Versus GDP Growth We do not expect growth to surge this time around. However, if monthly credit growth simply stabilizes at current levels, the credit impulse, which is just the change in credit growth, will turn positive. Chart 14 shows that the 6-month impulse is already moving higher. The 12-month impulse is still trending down, but if credit growth remains constant at its current pace, it will start hooking up this summer (Chart 15). Chart 14Rebound In Chinese 6-Month Credit Impulse Bodes Well For Metals Chart 15The 12-Month Credit Impulse Will Turn Up If Monthly Credit Growth Even Merely Stabilizes Importantly, the Li Keqiang index, a broad real-time measure of economic growth in China, is highly correlated with the 12-month credit impulse. As Chinese growth bottoms out this summer, global growth will start to reaccelerate. This will help boost global cyclical stocks as well as EM shares. My colleague, Arthur Budaghyan, BCA’s chief emerging markets strategist, remains bearish on EM equities in both relative and absolute terms. While this publication does not have a strong view on the relative performance of EM versus DM shares, we do expect EM stocks to rise in absolute terms over the remainder of the year. Accordingly, we sold our March-2019 EEM put on January 3rd for a gain of 104%, and are now outright long the ETF as one of our recommended trades. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com BOX 1 Do Banks Create Money Out Of “Thin Air”? Strictly speaking, banks can create deposits by issuing new loans without the need for economic savings (which economists define as the difference between what an economy produces and consumes). In that sense, banks can create money out of “thin air.” However, this does not mean, as is sometimes claimed, that economic savings are irrelevant to credit creation or that there is no effective limit on the volume of loans that banks can originate. Even if one ignores the presence of legal capital requirements, the public must still be willing to hold whatever deposits banks create. Just like the number of apples a society wishes to consume is simultaneously determined by the number of apples farmers wish to produce and the number of apples people wish to eat (with the price of apples equilibrating supply and demand), the answer to the question of whether loans create deposits or deposits create loans is always “both.” The aggregate volume of deposits that people wish to hold depends, among other things, on the level and distribution of net worth across society, as well as the rate of return that bank deposits offer compared to competing financial instruments (including cash, which pays nothing). A country’s net worth tends to be closely correlated with the value of its capital stock. Both are mainly determined by accumulated economic savings. Real interest rates are also largely determined by economic savings, especially at the global level, where rates adjust to ensure that world savings equals investment. The distribution of savings also matters. When some people wish to spend more than they earn, while others wish to do the opposite, debt levels will rise. The same is true for individual sectors of the economy. If there are some sectors that save a lot (such as households in China) and other sectors that borrow a lot (Chinese state-owned companies and local governments), debt levels will go up. Debt levels will also rise when people purchase assets using credit. Fresh economic savings are not necessary to finance the purchase of existing assets, but with the exception of undeveloped land and natural resources, economic savings are needed to create those assets (such as when a home is constructed or a factory is built). In China, a perfect trifecta of sky-high property prices, a high and uneven distribution of savings throughout the economy, and a financial sector that has been willing to intermediate savings without much regard for credit quality, have all contributed to the elevated debt levels we see today. Footnotes 1 Please see Global Investment Strategy Weekly Report, "Patient Jay," dated January 18, 2019. 2 Shang-Jin Wei and Xiao Zhang, "The Competitive Saving Motive: Evidence From Rising Sex Ratios And Savings Rates In China," Journal of Political Economy, Vol. 119, No. 3, 2011. 3 Please see Emerging Markets Strategy Special Report, “China Real Estate: A Never-Bursting Bubble?” dated April 6, 2018. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades
Highlights Buy the pound as soon as the U.K. parliament coalesces a majority around an action plan to counter a no-deal Brexit. For equity investors the best play is a FTSE Small Company Index ETF and/or U.K. REITS. Beaten-down banks, industrials and materials can continue their recent countertrend outperformances. This necessarily means that the cyclical-heavy Eurostoxx50 can continue its recent countertrend outperformance versus the S&P500. Go overweight industrials versus utilities as a tactical trade. Feature Chart of the WeekWere It Not For Brexit, U.K. Interest Rates Would be 1 Percent Higher Please join me for a webcast today at 10.00 AM EST (3.00 PM GMT, 4.00 PM CET, 11.00 PM HKT) when I will be elaborating on some of the ideas in this report as well as other major investment themes. For those of you who cannot participate live, the webcast will also be available as a playback. Were it not for the psychodrama called Brexit, the pound would be trading at $1.50 rather than at $1.28. We can say this with utmost confidence because ‘cable’ is very closely tracking the difference in 2-year interest rates in the U.K. versus the U.S. Absent the Brexit shenanigans, U.K. interest rates would be around 1 percent closer to those in the U.S., implying that pound/dollar would be around 15 percent higher ( Chart I-2 and Chart I-3 ). Chart I-2Absent The Brexit Discount On U.K. Interest Rates... Chart I-3...The Pound Would Be At $1.50 Explaining Brexit’s Impact On U.K. Interest Rates And The Pound The difference in U.K. versus U.S. interest rates usually tracks the difference in their inflation rates, in effect equalizing real interest rates in the two economies. But the Brexit referendum in 2016 forced the Bank of England into an ‘emergency monetary policy’ mode, whereby interest rates were left depressed relative to the inflation fundamentals, and U.K. real interest rates collapsed. Applying the BoE’s pre-Brexit reaction function to the current inflation dynamics, U.K. interest rates – and therefore the pound – would be in a completely different ballpark. After all, U.K. and U.S. core inflation rates and unemployment rates are virtually identical ( Chart of the Week ). It follows that the pound’s trajectory will be higher in any negotiated Brexit – or indeed ‘no Brexit’ – which avoids a complete and overnight no-deal divorce. The simple reason is that a transition period lasting several years that continues to give the U.K. access to the EU single market will allow the BoE to revert to its pre-Brexit monetary policy reaction function. But any workable alternative to a no-deal Brexit must satisfy two conditions: the way forward must be acceptable to the EU27; and it must command a majority in the U.K. parliament. From the perspective of investors, what this way forward turns out to be – Common Market 2.0, permanent customs union, second referendum, or general election – does not really matter. What matters is that a parliamentary majority exists for a course of action that avoids no-deal. The investment strategy is to buy the pound as soon as the U.K. parliament coalesces a majority around an action plan to counter a no-deal Brexit . In this event, do not buy the FTSE100. Whenever the pound strengthens, the weaker translation of the FTSE100 companies’ dollar-denominated earnings tends to weigh down this large-cap index. A better play is the FTSE250 mid-cap index ( Chart I-4 ), but for equity investors t he best play is a FTSE Small Company Index ETF and/or U.K. REITS ( Chart I-5 ). Chart I-4A Negotiated Brexit Would Favour The FTSE250... Chart I-5...And U.K. Small Companies Europeans Are Celebrating Lower Oil Europeans will be celebrating the near halving of the crude oil price from its $86 high just three months ago. The simple reason is that Europeans are net importers of energy, and the amount of energy they consume tends to be price inelastic. After all, Europeans have to do the school run and stay warm in winter, irrespective of the oil price. Hence, when energy prices soar as they did for most of 2018, it squeezes European real spending. Conversely, when energy prices plunge as they have more recently, it boosts real spending ( Chart I-6 ). A second transmission mechanism is via credit creation: higher inflation, through its implication for tighter monetary policy, lifts bond yields and depresses credit impulses; lower inflation does the opposite, it depresses bond yields and lifts credit impulses. The upshot is that higher oil weighed on European growth in 2018 while lower oil should boost growth in early 2019. Chart I-6Inflation Is Likely To Plunge, Boosting Real Incomes Compelling proof comes from the oscillations in the euro area economy. For several years, these growth oscillations have perfectly and inversely tracked oscillations in the oil price ( Chart I-7 ). The economic implication is that the recent collapse in energy prices should engineer some sort of growth rebound in the euro area. The investment implication is that such a growth rebound will support the classically cyclical equity sectors – banks, industrials and materials – because of their very high operational leverage to economic growth. Chart I-7Euro Area Growth Oscillations Inversely Track Oil Price Oscillations Profit is a small number created from the difference between two large numbers: sales minus the cost of generating those sales. But the dominant cost – the wage bill – tends to be quite sticky. Hence, if a company’s sales are highly sensitive to the economy, the power of operational leverage means that a small change in GDP can have a dramatically large proportional impact on profit. This is a simple principle, but it turns out to be an excellent explanation for the Eurostoxx50 earnings per share (eps) cycle. Because the index is dominated by the classically economic-sensitive sectors, Eurostoxx50 eps growth has a very high operational leverage to changes in euro area GDP growth, potentially as high as 50 times over short periods such as six months ( Chart I-8 ). In contrast the less cyclical S&P500 has an operational leverage to economic growth of less than 10 ( Chart I-9 ). Chart I-8Eurostoxx50 Profits Growth Is Highly Geared To Economic Growth Chart I-9S&P500 Profits Growth Is Less Geared To Economic Growth On the expectation that euro area growth will rebound modestly in early 2019, the beaten-down banks, industrials and materials can continue their recent countertrend outperformances. And this necessarily means that the cyclical-heavy Eurostoxx50 can continue its recent countertrend outperformance versus the S&P500. Explaining The ‘Unexplainable’ Moves In Markets During the recent Christmas holiday period, financial markets experienced sharp moves with no explainable catalyst. Such reversals leave many strategists and analysts scratching their heads in bewilderment, wondering: what was the catalyst for that reversal? The answer is there was no fundamental catalyst; the market reversed because liquidity dried up . But to explain why liquidity dried up and markets ‘unexplainably’ reversed, we first need to understand what creates market liquidity in the first place. Market liquidity is the ability to convert cash into an investment quickly and in volume without affecting its price. But for an investor to convert a large amount of cash into an investment without affecting its price, another investor must be willing to do the exact opposite – convert a large amount of the investment into cash at the given price. Therefore, market liquidity comes from a disagreement about the attractiveness of an investment at that given price. Investors disagree about the attractiveness of an investment at a given price because investors with different time horizons interpret the same facts and information very differently. Hence, a market remains stable when it possesses investors with many different time horizons. The reason is that when a day-trader experiences a ‘six-sigma’ price move, an investor with a longer investment horizon, for example 65 days, will step in and stabilize the market. The longer-term investor will do so because, within his investment horizon, the day-trader’s six-sigma price move is not unusual. As long as another investor has a longer trading horizon than the investor experiencing an extreme event, the market will stabilize itself. Therefore, the market’s liquidity and stability are maximized when its participants possess a variation of investment horizons, say, both the 1 day horizon and the 65 day horizon. The corollary is that the market’s liquidity and stability disappear when its participants no longer possesses this healthy variation in horizons. In technical terms, this occurs when the market’s 65-day fractal dimension collapses to its lower bound. Without a shadow of a doubt, this is what happened to the S&P500 on Christmas Eve and triggered a 5 percent market rebound on Boxing Day ( Chart I-10 ). And this is now what is happening to the relative performance of industrials versus utilities, which is also in the process of a similar liquidity-triggered rebound ( Chart I-11 ). Chart I-10A Liquidity Shortage Triggered A Sharp Rebound In The S&P500 Chart I-11Expect A Liquidity-Triggered Rebound In Industrials Versus Utilities Fractal Trading System* This week we note that the strong rally in the Indian rupee versus the Pakistan rupee has reached a point where an imminent liquidity shortage could trigger a countertrend move. Go short the Indian rupee versus the Pakistan rupee with a profit target of 3 percent, and a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-12 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Dhaval Joshi , Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
The annual rate of change in China’s total social financing adjusted for local government special bonds issuance continues to decelerate, growing at 10%. Consequently, the 12-month credit impulse is still deteriorating. An imminent end to China’s cyclical…
Highlights Dear Clients, This is the final publication for the year, in which we recap some of the key developments in 2018. We will resume our regular publishing schedule on January 2, 2019 with a Special Report on urbanization/industrialization. The China Investment Strategy team wishes you a very happy holiday season and a prosperous New Year! Best regards, Jonathan LaBerge, CFA, Vice President Special Reports The evidence over the past year raises the odds that China’s economy has entered a multi-year period of frequent mini-cycles. A mini-cycle world would be a difficult one for investors to navigate, particularly if the boom and bust phases are asymmetrical in length or magnitude. There is no magic wand to quickly transform China into a services-oriented economy, and it is not clear that the gains in tertiary sector GDP since 2010 are sustainable. A slow transition would raise deep questions about China’s growth model over the coming 2-3 years, and would create a major dilemma for policymakers. Chinese stocks are considerably cheaper than they were a year ago, yet they may be cheap for a reason (even over the very long term). On a risk-adjusted basis, we do not find the value proposition to be compelling, meaning that our recommended multi-year allocation to Chinese stocks is neutral barring even lower prices or tangible evidence of successful structural reforms. Feature Following the publication of our special year end Outlook report for 2019,1 BCA's China Investment Strategy service recently expanded on our global view by outlining our three key themes for China over the coming year.2 As a year-end tradition, we dedicate this week's report to recapping some important developments of the past year and their longer-term implications. Mini-Cycles, And The Policy Trade-Off Between Growth And Leveraging Over the past year we have described the progression of Chinese growth as part of an economic “mini-cycle”, one that actually began in early-2014 (we have focused on the expansion period of the cycle that started in mid-2015). While this is the first clear mini-cycle in China after a prolonged period of slowing activity that followed the enormous stimulus of 2008/2009, many investors and market participants have speculated about whether these types of events will become more prevalent in the future. In a March 2017 BCA Special Report,3 my colleague Arthur Budaghyan speculated about the potential for such cycles within the context of a falling primary growth trend. Arthur’s argument was that cyclical growth could hold up in China over the coming few years only if the government allows credit growth to continue booming, but that this would entail creeping socialism/statism that would cripple the country’s productivity and thus its potential growth. In fact, the experience of the past three years suggests that mini-cycles may occur over the coming few years even if policymakers do try to prevent a falling primary growth trend. Chart 1 shows that the slowdown in domestic demand that investors only began to price in the middle of this year has clearly been caused by a slowing in money & credit growth (as represented by our leading indicator), which in turn strongly appears to have occurred because of monetary tightening that began at the end of 2016 (panel 2). This tightening has been closely linked to the government’s attempt to de-risk the financial sector. Chart 1Tighter Monetary Policy Caused The Recent Mini-Cycle Slowdown In addition, we presented evidence in our August 29 Special Report suggesting that Chinese state-owned enterprises (SOEs) now have a negative net return on borrowed funds (Chart 2), underscoring that Chinese authorities now face a policy trade-off between growth and leveraging.4 The inference is that investors can expect more of these episodes so long as policymakers stay committed to reforming the financial sector, a policy that appears to remain a strong priority of the Xi government. Chart 2SOEs Now Have A Negative Net Return On Borrowed Funds Chart 3 presents three stylized scenarios as a possible multi-year roadmap for investors faced with a “mini-cycle world”. Scenario 1 represents the pessimistic case articulated by Arthur, a set of frequent cycles occurring against the backdrop of a falling primary (or potential growth) trend. Scenarios 2 and 3 represent possible outcomes emerging from successful structural reform: in scenario 2 the downtrend in potential growth is arrested and the primary growth trend becomes flat, whereas scenario 3 depicts the optimistic case, where reform initiatives unleash productivity gains that result in a net increase in potential growth. In both scenarios 2 and 3, the frequency of economic cycles is reduced to be more akin to that of typical business cycles in the developed world, ending the more rapid mini-cycle phase that preceded the success of the reforms. Chart 3A Potential Roadmap For Investors Living In A "Mini-Cycle World" For an investor primarily concerned with cyclical asset allocation, one response to Chart 3 might be that any of the scenarios are acceptable because there is money to be made in each case by shifting one’s investment stance in advance of key inflection points. However, as Arthur alluded to in last year’s report, the cycles depicted in Chart 3 are highly stylized and will not repeat themselves over regular, predictable intervals. In addition, even in scenarios 2 and 3, the higher frequency of oscillations depicted in the chart prior to the positive impact of structural reforms means that a mini-cycle world will be a difficult one for investors to navigate, particularly if the boom and bust phases are asymmetrical in length or magnitude. From a longer-term perspective, Chart 3 clearly outlines two key questions that investors should be asking themselves about China if we truly have entered a multi-year period of frequent mini-cycles: Is there tangible evidence of a falling primary growth trend in China, and can this be detected ex-ante rather than ex-post? What are the markers for successful structural reform, and how can progress be tracked in real-time? These are of course difficult questions to answer, and our thoughts are likely to evolve as more evidence presents itself. However, for now, we note the following: Chart 4 presents some evidence of declining potential growth in China, or more precisely a decline in the natural rate of interest. The chart shows that the rise in the weighted average lending rate since late-2016 was relatively minor compared with levels that have prevailed over the past decade, and yet it is clear that it succeeded in materially slowing the investment-driven sectors of China’s economy. Chart 4There Is Some Evidence That China's Natural Rate Of Interest Has Declined We also presented some evidence in our November 21 Weekly Report showing that China’s monetary policy transmission mechanism is impaired.5 Chart 5 shows that the recent decline in interbank repo rates implies that average lending rates are set to decline materially over the coming months; measuring the strength of the reaction in the old economy to this decline will provide investors with another crucial observation about the responsiveness of the economy to interest rates. Chart 5More Information On The Responsiveness Of The Economy To Interest Rates Will Soon Emerge Concerning potential signposts of successful structural reform, signs that the government is about to undertake a big-bang cleanup and reorganization of China’s SOEs, one that involves the large-scale transfer of bad SOE debts to the public sector, would obviously be the primary event for investors to watch for. We assume that this will not occur over the coming few years barring a major crisis. At the firm level, non-trivial deleveraging, privatization/incorporation, material capital injection/withdrawal, material divestment of non-core fixed assets and (to a lesser degree) reduction in the wage bill relative to the industry have all shown themselves to be significantly related to the odds of a “zombie” firm returning to a healthy financial state.6 Even quiet signs that SOEs may be going through this process would be a positive indication of the potential for reform. At the macro level, our signposts of successful structural reform would be indications that SOE return on assets is set to rise back above borrowing costs (because of a material rise in the former, not a significant decline in the latter), tangible evidence of passive deleveraging (debt to nominal GDP falling because of a sustained rise in the latter), and a structural rise in the presence of private firms in China’s economy. Chart 6 shows that, at least in the case of the latter, progress appears elusive. Chart 6The Size Of The Private Sector In China Is Now Moving In The Wrong Direction Over the shorter-term, global investors are strongly focused on whether we are about to enter another mini-cycle upswing, a view that we have recently argued against. We presented our base case view for 2019 in our December 5 Weekly Report2, which is that growth will modestly firm in the second half of 2019 and will provide a somewhat stronger demand backdrop for commodities and emerging economies that sell goods to China. But we underscore that the character of the improvement is likely to be materially different than what occurred in 2016, implying that investors betting on substantial returns from China-related financial assets next year are likely to be disappointed. Transitioning To A Services-Oriented Economy: There Is No Magic Wand Part of the structural reform agenda articulated by Xi Jinping involves transitioning China's economy towards the tertiary sector (services). Services activity, in general, tends to have higher added value than manufacturing, construction, and raw material extraction, and it is hoped that a more services-oriented economy will increase China’s per capita GDP and help the country escape the middle-income trap. Chinese policymakers have been very clear about their intention to promote this shift and have emphasized their need to do so quickly, but have not been very clear about how they plan to do so. Admittedly, there is some evidence to suggest that this trend has already begun: Chart 7 shows that tertiary industry GDP has risen as a share of overall GDP by about 7.5 percentage points since 2010, tertiary industry electricity consumption as a share of total is rising steadily, and the market capitalization of information and communication technology-related sectors has risen in China’s domestic and investable equity market (sharply in the case of the latter).7 Chart 7Some Signs Of A Move Towards Services... However, BCA’s China Investment Strategy service has been and remains quite skeptical about the likely pace of this transition, which raises deep questions about China’s growth model over the coming 2-3 years: Chart 8 breaks down the increase in tertiary industry GDP as a share of total from 2010 – 2017 into individual sectors.8 The chart shows that finance-related sectors (financial intermediation, leasing & business services, and real estate) accounted for nearly half of the increase in services GDP over the period. It seems difficult to expect that this trend will continue in an environment where the government is trying to contain financial sector risk. Chart 8 shows that tech-related sectors accounted for the second largest increase in tertiary industry GDP over the period, which is not surprising given the data shown in panel 3 of Chart 7. However, there are three problems with assuming that China’s tech sector will expand at a very rapid pace from current levels. First, Chart 9 makes it clear that the incubation period for China’s largest two technology companies by market capitalization was quite long. Alibaba and Tencent were both formed nearly 20 years ago, and only recently gained significant traction. Second, neither of these firms appears to have succeeded because of Chinese industrial policy, underscoring the importance of dynamic, competitive, private markets in driving innovation. Third, other successful examples of “breakthrough” state support for industries show that the process is not a rapid one. In the U.S. between 1978 and 1992, the U.S. Department of Energy invested in the Eastern Gas Shale Program, which contributed somewhat to the development of fracking technology used in shale oil & gas production today. Chart 10 shows how long it took for this program to bear fruit: gas production began to trend higher 12 years after the end of the program, whereas it took nearly two decades for oil production to begin to move higher. And even in this case, the role of private industry in commercializing the technology was overwhelmingly dominant. Chart 9The Incubation Period Of China's Major Tech Success Stories Was Quite Long Chart 10The Dividends From State-Assisted R&D Can Take A Long Time To Occur It is encouraging to see that education spending in China has increased as a share of GDP over the past several years, as services activity typically requires a highly educated workforce as an input. But China’s post-secondary educational attainment (defined here as the share of 25-34 year olds with tertiary education) appears to be too low to make a meaningful leap over the next 2-3 years (Chart 11). We acknowledge that China’s educational achievement ranks quite highly relative to the world, and this speaks to the high quality of skilled labor in China. However, for now, China’s attainment rate appears to be too low for the country to rapidly shift to services. Finally, Chart 12 shows that while tertiary industry electricity consumption is rising as a share of total, it remains small compared with secondary industry consumption. This underscores that China’s shift to a truly-services oriented economy is something that will take a considerable amount of time. What does a slow transition from secondary to tertiary industry mean for investors? To us, it either raises the risk that: Chart 12A Long Way To Go policymakers will have to rely on China’s old growth model for longer than they intend, or that Chinese growth will slow considerably more over the coming few years than investors currently expect. In the first case, policymakers may be on a collision course with the reality of poor financial health among SOEs, which as we noted earlier already have a negative net return from leveraging. In the second case, the threat is clear: China’s contribution to global growth could decline sharply, with potentially severe consequences for China-related financial assets. Cheap(er) Chinese Stocks: A Great Long-Term Buying Opportunity? We have received several questions from clients over the past few months asking whether they have been presented with a great long-term buying opportunity for Chinese stocks, even if cyclical economic conditions are set to weaken from current levels. Chart 13In The U.S., Valuation Predicts Long-Term Returns Quite Successfully This is a valid line of inquiry. Over a 6-12 month time horizon, valuation rarely drives asset returns, and we recently argued against the view that valuation could act as an overwhelming rally catalyst for Chinese stocks in 2019. However, we agree that valuation should be increasingly considered as one’s time horizon expands. Chart 13 shows that valuation has been a powerful predictor of 10-year future performance for the U.S. equity market, and Chart 14 shows that the forward P/E ratio for both domestic and investable Chinese stocks has certainly improved over the past several months. In relative terms, Chinese stocks are not as cheap as they have ever been, but haven’t usually been cheaper (at least over the past decade). This is particularly true for the A-share market (Chart 15). Chart 14Chinese Stocks Are Now Considerably Cheaper Than A Year Ago...Chart 15...Although They Have Been Cheaper In Relative Terms We struggle to answer the question, because while valuation usually predicts future returns quite well, deviations from this relationship can exist. Chart 13 shows that material differences between the actual and predicted 10-year returns existed during the 1970s/early-1980s and as well during the late-1990s, and would have as well in 2008/2009 had the valuation extremes of the late-1990s not lined up so well with the timing of the global financial crisis a decade later. In short, cheap stocks can be cheap for a reason, and the structural issues that we noted above certainly highlight the potential for the next 10-years of Chinese equity market performance to be anomalous relative to what would normally be implied by current valuation. For now, the best answer we can provide is that Chinese stocks are a great long-term buy for investors who do not share our structural concerns. On a risk-adjusted basis, we do not find the value proposition to be compelling, meaning that our recommended multi-year allocation to Chinese stocks is neutral. But we will be watching closely over the coming few years for signs of successful structural reform as detailed above, and we are likely to upgrade our structural recommendation on any material progress, particularly if that progress involves a cyclical deterioration in the economy that further cheapens equities. Stay tuned! Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1 Pease see The Bank Credit Analyst “OUTLOOK 2019: Late-Cycle Turbulence”, dated November 27, 2018, available at cis.bcaresearch.com. 2 Pease see China Investment Strategy Weekly Report “2019 Key Views: Four Themes For China In The Coming Year”, dated December 5, 2018, available at cis.bcaresearch.com. 3 Pease see China Investment Strategy Special Report “The Great Debate: Does China Have Too Much Debt Or Too Much Savings? ”, dated March 23, 2017, available at cis.bcaresearch.com. 4 Pease see China Investment Strategy Special Report “Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging”, dated August 29, 2018, available at cis.bcaresearch.com. 5 Pease see China Investment Strategy Weekly Report “Trade Is Not China’s Only Problem”, dated November 21, 2018, available at cis.bcaresearch.com. 6 IMF Working Paper WP/17/266 “Resolving China’s Zombies: Tackling Debt and Raising Productivity” 7 Note that we have included the consumer discretionary sector in Chart 8 owing to the recent GICS sector changes that have included e-commerce providers such as Alibaba in the discretionary sector. 8 Note that 2016 is the most recent data point for healthcare & social security, education, scientific research & technology services, public management & social organizations, and miscellaneous others. However, their change from 2010 – 2017 reflects almost all of the change in the sum of these categories from 2010 – 2017. Cyclical Investment Stance Equity Sector Recommendations
As we have previously wrote in these pages, the primary role of central banks is to ensure price stability. That objective is achieved by cooling economic activity by raising interest rates, which weighs on various cyclical sectors in the economy. Given that…
Rudi Dornbusch, a preeminent academic on international economics in the post-war period, once said that: “None of the post-war expansions died of old age. They were all murdered by the Fed.” Beyond noticing from this quote that Rudi was probably a very witty…
Highlights Our take on the key macro drivers of financial markets hasn’t evolved much since we laid it out this summer, … : Monetary policy is still accommodative; lenders are ready, willing and able; and the expansion remains intact. ... but the inflection points are getting nearer: The good times won’t last forever, though. The Fed is resolutely tightening policy, BBB-heavy investment-grade issuance has the corporate bond market flirting with a plague of fallen angels, and the global economy is slowing. Our strategy remains more cautious than our outlook for now, … : Although we think the equity bull market has another year to run, and the expansion will stretch into 2020, we are only equal-weight equities, while underweighting bonds and overweighting cash. … but we’re alert to opportunities to get more aggressive: Investment-grade and high-yield bonds are unlikely to offer an attractive risk-reward profile, but the S&P 500 shouldn’t decline much more if the economy holds up. Feature Mr. and Ms. X’s annual visit is an occasion for every BCA service to look toward the coming year, mindful of how it could improve on the one just past. The theme we settled on in last year’s discussion, Policy and Markets on a Collision Course, began asserting itself in earnest in October, and appears as it will be with us throughout 2019. The Fed is nearing its fourth rate hike this year, on the heels of three in 2017, and markets are warily contemplating the tipping point at which higher interest rates begin to interfere with activity. The yield curve has become a constant worry (Chart 1), with short rates moving in step with the fed funds rate while yields at the long end have been just one-half as sensitive (Chart 2). Chart 1Yield Curve Anxiety Has Exploded ... Chart 2... As The Curve Has Steadily Flattened Trade tensions are an even thornier policy challenge. After flitting on and off investors’ radar earlier in the year, trade barriers have been a major source of angst in recent months as central banks, investor polls and company managements increasingly cite them among their foremost concerns. Unfortunately, our geopolitical strategists do not expect relief any time soon. They see trade as just one aspect of an extended contest for supremacy between China and the U.S. Late-Cycle Turbulence, our 2019 house theme, pairs nicely with Policy-Market Collision. The gap between our terminal fed funds rate expectation and the money market’s is huge, and leaves ample room for a repricing of the entire yield curve. Trade has been a roller coaster, capable of inducing whiplash in 140 characters or less, and it may already have brought global manufacturing to the brink of a recession. Oil lost 30% in two months at the stroke of a pen; its immediate fate is in the hands of OPEC, but the caprice with which Iranian sanctions may or may not be re-imposed is likely to feed uncertainty. As we advised Mr. and Ms. X a few weeks ago, investors should stay nimble; there is no point to committing to a twelve-month strategy right now.1 The Fed Funds Rate Cycle Our equilibrium fed funds rate model estimates that the equilibrium fed funds rate, the rate that neither encourages nor discourages economic activity, is currently around 3%. It projects that the equilibrium rate will approach 3¼% by the middle of 2019, and 3⅜% by year end. The implication is that policy is comfortably accommodative now, and will not cross into restrictive territory for another 12 months – assuming that the Fed hikes four times next year, in line with our ambitious expectation. If the Fed steps back from its gradual pace, and only hikes three times in 2019 (as per the dots), or just once (as per the money market), the day when the economy and markets will have to confront tight monetary conditions will be pushed even further into the future. Stretching monetary accommodation until late next year would seem to forestall the arrival of the next recession until at least the first half of 2020. Tight policy is a necessary, if not sufficient, condition for a recession, as recessions have only occurred when the policy rate has exceeded our estimate of equilibrium over the six decades covered by our model. A longer stretch of accommodation would also continue to nourish the equity bull market and discourage allocations to Treasuries. Over the last 60 years, the S&P 500 has accrued all of its real returns when policy was easy (Table 1), while Treasuries have wilted, especially in the current phase of the fed funds rate cycle (Table 2). Table 1Equities Flourish When Policy’s Easy ... Table 2... While Treasuries Stumble The Business Cycle The state of policy is one of the three components in our simple recession indicator. Neither of the other two is sounding the alarm, either. Our preferred 3-month-to-10-year segment of the Treasury yield curve is still comfortably upward sloping, even if it has been steadily flattening and we expect it to invert late next year (Chart 3). Year-over-year growth in leading economic indicators decelerated slightly last month, but remains well above the zero line that has reliably preceded past recessions. Chart 3Flattening, But Not Yet Flat The Credit Cycle Anyone following the credit cycle would do well to start with the axiom that bad loans are made in good times. Its converse is just as true: good loans are made in bad times. Loan officers are every bit as susceptible to the recency bias as other human beings, and they tend to extrapolate from the freshest observations when assessing a borrower’s prospects. When things are good, lenders assume they will continue to be good, and let their guard down by lending to marginal borrowers and/or relaxing the terms on which they will lend. When things are bad, on the other hand, loans have to be underwritten so tightly that they squeak. The upshot is that lending standards and loan performance are tightly bound up with one another. In the near term, standards and performance are joined at the hip; over a five-year period, standards lead performance as a contrary indicator. Defaults almost certainly bottomed for the cycle in 2014, to judge by speculative-grade bonds (Chart 4, top panel), and loans (Chart 4, bottom panel). Standards reliably followed, and the proportion of lenders easing standards for corporate borrowers, as per the Fed’s senior loan officer survey, spiked (Chart 5). Chart 4Weakening, But Not Yet Weak Chart 5Standards Follow Performance In Real Time ... The 2012 and 2014 peaks in willingness suggest that performance is due to erode (Chart 6). We do not foresee a step-function move higher in defaults, or a sudden collapse in loan availability, but we do expect some fraying at the edges. Given how tight spreads remain, any weakness at the margin could go a long way to wiping out much, if not all, of spread product’s excess return. The bottom line is that the credit cycle is well advanced, and investors should expect borrower performance and lender willingness to weaken from their current levels. Chart 6... And Lead Them Over The Intermediate Term Bonds We have written at length on our bearish view on rates and Treasuries.2 The key pillar supporting our rationale is the gap between our terminal fed funds rate estimate, 3.5-4%, and the market’s view that the Fed will not go beyond 2.75%, if indeed it gets to that level at all (Chart 7). The gap is big enough to drive a truck through, and leaves a lot of room for yields to shift higher all along the curve, even if the Fed were to slow its 25-bps-a-quarter tempo, as the Wall Street Journal suggested it might in a report last Thursday. We continue to believe that inflation is the inevitable outcome once surging aggregate demand collides with limited spare capacity, and that the Fed will be forced to push the fed funds rate to 3.5% and beyond. Chart 7Something's Gotta Give Our view that the credit cycle has already passed its peak drives our view on spread product. Though we remain constructive on the economy and the outlook for corporate earnings, we are not enamored of the risk-reward offered by corporate bonds. Although high-yield spreads blew out by nearly 125 bps from early October to late November, high yield still does not look cheap (Chart 8, bottom panel). The same holds for investment-grade spreads, which remain near the bottom of their long-term range despite widening by over 50 bps (Chart 8, top panel). Chart 8Spreads Are Still Tight Bottom Line: We recommend that investors underweight fixed income within balanced portfolios, while underweighting Treasuries and maintaining below-benchmark duration. We recommend benchmark holdings in spread product, but we expect to downgrade it to underweight before the end of the first half. Equities With monetary policy still accommodative, and the expansion still intact, the cyclical backdrop is equity-friendly. If we’re correct that policy won’t turn restrictive for another twelve months or so, the bull market should have about another year to go. We downgraded equities to equal weight as a firm in mid-June nonetheless, on signs of global deceleration and the potentially malign effects of tariffs and other impediments to global trade. U.S. Investment Strategy fully supported that decision, but we are alert to opportunities to upgrade equities to overweight within U.S. portfolios if prices decline enough to make the prospect of a new cycle high attractive on a risk-reward basis. The risk-reward requirement implies that the fall in price would have to occur without a material weakening of the fundamental backdrop. For now, we think the fundamental supports remain stable, as per the equity downgrade checklist we constructed to keep tabs on them. The checklist monitors recession indicators, none of which betray any concern now; factors that may weigh on corporate earnings; inflation measures, because higher inflation could motivate the Fed to hike more quickly than planned, with adverse consequences for the bull market; and signs of overexuberance (Table 3). Table 3Equity Downgrade Checklist The earnings-pressure section focuses on the key factors that might signal margin contraction – wage growth, dollar strength and rising bond yields – but none of them look especially problematic now. While we think compensation gains will eventually push the Fed to go beyond its own terminal rate estimates, they have not yet picked up enough to cause concern. The dollar has paused in its advance, mostly marking time since the end of October. Only BBB corporate yields have gotten closer to checking the box (Chart 9). BCA’s preferred margin proxies remain in good shape, on balance (Chart 10), and our EPS profit model is calling for robust profit growth across all of next year (Chart 11). Chart 9Higher Rates Will Exert Some Margin Pressure Chart 10In The Absence Of Margin Pressures, ... Chart 11... 2019 Earnings Could Hold Up Nicely Oil’s plunge has pulled both headline CPI and longer-run inflation expectations lower. Although we think that the inflation respite is merely a head fake, and that oil will soon regain its footing (please see below), the run of harmless inflation data has the potential to soothe some market concerns about the Fed. If the Fed itself takes the data at face value, it may signal that the current 25-bps-a-quarter gradual pace could be slowed. As for exuberance, the de-rating the S&P 500 has endured since its forward multiple peaked at 18.5 in January suggests that it’s not a problem. We are not living through anything remotely resembling an equity mania. Bottom Line: BCA’s mid-June downgrade of global equities from overweight to equal-weight was timely. We remain equal-weight in balanced U.S. portfolios, but are more likely to upgrade U.S. equities than downgrade them, given the supportive cyclical backdrop. Oil We devoted our report two weeks ago to the oil outlook and its implications for the economy. Our Commodity & Energy Strategy service’s bullish 2019 view has not changed: it still sees a market in a tight supply/demand balance with high potential for supply disruptions and a smaller-than-usual inventory reserve to make up the slack. The unexpected release of over a million barrels a day of Iranian output has played havoc with oil prices, but does not provoke the growth concerns that declining demand would. Provided OPEC is able to agree on production cuts, and abide by them going forward, our strategists see Brent and WTI averaging $82 and $76/barrel across 2019. The Dollar We remain bullish on the dollar, though it will find the going rougher than it did in 2018. Traders have built up sizable net long positions, so it will take more for the greenback to extend its advance than it did to begin it. Ultimately, we think desynchronization between the U.S. and the rest of the major DM economies will keep the dollar moving higher. If the U.S. does not continue to outgrow the currency-major economies by a healthy margin, and/or the Fed does not respond to that growth by hiking rates to prevent overheating, the dollar’s advance may be nearly played out. Putting It All Together Three major assumptions underpin our views: The U.S. economy is at risk of overheating in its second year of markedly above-trend growth fueled by fiscal stimulus, and the Fed will respond to that risk by decisively raising rates. There will be a noticeable global slowdown, but it will not go far enough to turn into a recession. The U.S. will remain mostly immune to the global slump. We will be positioned well if all of these assumptions are validated by events, though timing is always uncertain. Financial-market volatility often increases late in the cycle, and we expect the backdrop to remain fluid. We are trying to maintain a fluid mindset in kind, monitoring the incoming data to make sure our cyclical assessments still apply, while remaining alert to opportunities created by significant price swings. Although we are neither traders nor tacticians, we want to retain some flexibility, and are trying to resist mentally locking in our positioning for the entire year. We are particularly focused on the monetary policy backdrop and the transition from accommodative to restrictive policy, which has historically been critically important for asset allocation. Our main goal is to anticipate the approach of inflection points in the key cycles – business, credit and monetary – as adeptly as we can. We are also resolved to look through the noise of one-off price swings and the blather that has already been clogging the airwaves. We seek to help our clients formulate a strategy for navigating the turbulence without being swept up in it. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com Footnotes 1 Please see the December 2018 Bank Credit Analyst, “Outlook 2019: Late-Cycle Turbulence,” available at www.bcaresearch.com. 2 Please see the July 30, 2018 U.S. Investment Strategy, “The Rates Outlook,” the September 17, 2018; U.S. Investment Strategy, “What Would It Take To Change Our Bearish Rates View?” and the November 5, 2018; U.S. Investment Strategy, “Checking In On Our Rates View,” available at usis.bcaresearch.com.
Highlights Downside risks to EM assets remain substantial. Stay put. EM stocks, credit and currencies will underperform their DM counterparts in the first half of 2019. The key and necessary condition for a new secular EM bull market to emerge is the end of abundant financing. The latter is imperative to compel corporate restructuring, bank recapitalization as well as structural reforms. The cyclical EM outlook hinges on China’s business cycle. The slowdown in China is broad-based and will deepen. The slowdown in China/EM will likely lead to global trade contraction. The latter is negative for global cyclicals yet bullish for the U.S. dollar. Feature As we head into 2019, the past decade is shaping up to be a lost one for emerging markets (EM) assets. In particular: EM stocks have underperformed DM markets substantially since the end of 2010 (Chart I-1). In absolute terms, EM share prices are at the same level as they were in early 2010. Chart I-1EM Equities Have Been Underperforming DM For Eight Years EM currencies have depreciated substantially since 2011, and the EM local currency bond index (GBI-EM) on a total-return basis has produced zero return in U.S. dollar terms since 2010 (Chart I-2). Chart I-2A Lost Decade For Investors In EM Local Currency Bonds? Finally, EM sovereign and corporate high-yield bonds have not outperformed U.S. high-yield corporate bonds on an excess-return basis. Will 2019 witness a major reversal of such dismal EM performance? And if so, will it be a structural or cyclical bottom? The roots underneath this lost decade for EM stem neither from trade wars nor from Federal Reserve tightening. Therefore, a structural bottom in EM financial markets is contingent neither on the end of Fed tightening nor the resolution of current trade tussles. We address the issues of Fed tightening and trade wars below. A Lost Decade: Causes And Remedies What led to a lost decade for EM was cheap and plentiful financing. When the price of money is low and financing is abundant, companies and households typically rush to borrow and spend unwisely. Capital is misallocated and, consequently, productivity and real income growth disappoint – and debtors’ ability to service their debts worsens. This is exactly what has happened in EM, as easy money splashed all over developing economies since early 2009. There have been three major sources of financing for EM: Source 1: Chinese Banks Chinese banks have expanded their balance sheets by RMB 198 trillion to RMB 262 trillion (or the equivalent of $28.8 trillion) over the past 10 years (Chart I-3, top panel). When commercial banks expand their balance sheets by lending to or buying an asset from non-banks, they create deposits (money). Consistently, the broad money supply has expanded by RMB 175 trillion to RMB 234 trillion (or the equivalent of $25.5 trillion). Chart I-3Enormous Boom In Chinese Banks' Assets And Money Supply Notably, the People’s Bank of China (PBoC) has increased commercial banks’ excess reserves by RMB 1.5 trillion to RMB 2.8 trillion (or the equivalent of $0.22 trillion) (Chart I-3, bottom panel). Hence, the meaningful portion of money supply expansion has been due to the money multiplier – money created by mainland banks – not a provision of excess reserves by the PBoC (Chart I-4). Chart I-4Attribution Of Rise In Money Supply To Excess Reserves And Money Multiplier Not only has such enormous money creation by commercial banks generated purchasing power domestically, but it has also boosted Chinese companies’ and households’ purchases of foreign goods and services. The Middle Kingdom’s imports of goods and services have grown to $2.5 trillion compared with $3.2 trillion for the U.S. (Chart I-5). China’s spending has boosted growth considerably in many Asian, Latin American, African, Middle Eastern, and even select advanced economies. Chart I-5Imports Of Goods And Services: China And The U.S. Source 2: DM Central Banks’ QE By conducting quantitative easing, the central banks of several advanced economies have crowded out investors from fixed-income markets, incentivizing them to search for yield in EM. The Fed, the Bank of England, the European Central Bank and the Bank of Japan have in aggregate expanded their balance sheets by $10 trillion (Chart I-6). Chart I-6Quantitative Easing In DM This has led to massive inflows of foreign portfolio capital into EM, and reflated asset prices well beyond what was warranted by their fundamentals. Specifically, since January 2009, foreign investors have poured $1.5 trillion on a net basis into the largest 15 developing countries excluding China, Taiwan and Korea (Chart I-7, top panel). For China, net foreign portfolio inflows amounted to $560 billion since January 2009 (Chart I-7, bottom panel). Chart I-7Cumulative Foreign Portfolio Inflows Into EM And China Source 3: EM Ex-China Banks EM ex-China began expanding their balance sheets aggressively in early 2009, originating new money (local currency) and thereby creating purchasing power. This was especially the case between 2009 and 2011. Since that time, money creation by EM ex-China banks has decelerated substantially due to periodic capital outflows triggering currency weakness and higher borrowing costs. Out of these three sources, China’s money/credit cycles remain the primary driver of EM. The mainland’s imports from developing economies serves as the main nexus between China and the rest of EM. Essentially, Chinese money and credit drive imports, influencing growth and corporate profits in the EM universe (Chart I-8). Chart I-8China's Credit Cycle Leads Its Imports In turn, EM business cycle upturns attract international capital. Meanwhile, credit creation by local banks in EM ex-China – primarily in economies with high inflation or current account deficits – is a residual factor. In these countries, domestic credit creation is contingent on a healthy balance of payments and a stable exchange rate. The latter two, in turn, transpire when exports to China and international portfolio capital inflows are improving. The outcome of easy financing is over-borrowing and capital misallocation. The upshot of the latter is usually lower efficiency and productivity growth. Not surprisingly, productivity growth in both China and EM ex-China has decelerated considerably since 2009 (Chart I-9). EM return on assets has dropped a lot in the past 10 years and is now on par with levels last seen during the 2008 global recession (Chart I-10). Chart I-9Falling Productivity Growth In EM And China =... Chart I-10... = Low Profit Margins And Low Return On Capital Accordingly, the ability to service debt by EM companies has deteriorated considerably in the past decade – the ratios of cash flows from operations to both interest expenses and net debt have dropped (Chart I-11). Chart I-11EM: Deteriorating Ability To Service Debt These observations offer unambiguous confirmation that money has been spent inefficiently – i.e., misallocated. Credit booms and capital misallocations warrant a period of corporate restructuring and banking sector recapitalization. Without this, a new cycle cannot emerge. A secular bull market in equities and exchange rates arises when productivity growth and hence income-per-capita growth accelerates, and return on capital begins to climb. This is not yet the case for most developing economies. The end of cheap and abundant financing is imperative to compel corporate restructuring, bank recapitalization as well as structural reforms. These are necessary conditions to create the foundation for a new secular bull market. Ironically, the best remedy for an addiction to easy money is a period of tight money. For example, U.S. share prices would not be as high as they currently are if the U.S. did not go through the Lehman crisis. This 10-year bull market in U.S. equities was born from the ashes of the Lehman crisis. Vanished financing and the private sector’s tight budgets in 2008-‘09 compelled corporate restructuring as well as a focus on efficiency and return on equity. Has EM financing become scarce and tight? Cyclically, China’s money creation and credit flows have slowed, pointing to a cyclical downturn in EM share prices and commodities (please see below for a more detailed discussion). International portfolio flows to EM have also subsided since early this year. There has been selective corporate restructuring post the 2015 commodities downturn, including in the global/EM mining and energy sectors, China steel and coal industries as well as among Russian and Brazilian companies. However, there are many economies and industries where corporate restructuring, bank recapitalization and structural reforms have not been undertaken. Yet from a structural perspective, China’s money and credit growth remain elevated and excesses have not been purged. Besides, international portfolio flows to EM have had periodic “stop-and-gos” but have not yet retrenched meaningfully (refer to Chart I-7 on page 4). Consequently, structural overhauls and corporate restructuring in China/EM have by and large not yet occurred – in turn negating the start of a new secular bull market. Bottom Line: Conditions for a structural bull market in EM/China are not yet present. EM/China: A Cyclical Bottom Is Not In Place From a cyclical perspective, China is an important driving force for the majority of EM economies, and its deepening growth slowdown will continue to weigh on EM growth and global trade. In fact, odds are that global trade will contract in the first half of 2019: In China, tightening of both monetary policy as well as bank and non-bank regulation from late 2016 has led to a deceleration in money and credit growth. The latter has, with a time, lag depressed growth since early this year. Policymakers have undertaken some stimulus since the middle of this year, but it has so far been limited. Stimulus also works with a time lag. Besides, even though the broad money impulse has improved, the credit and fiscal spending impulse remains in a downtrend (Chart I-12). Therefore, there are presently mixed signals from money and credit. Chart I-12China's Stimulus Leads EM And Commodities As illustrated in Chart I-12, the bottoms in the money and combined credit and fiscal spending impulses, in July 2015, preceded the bottom in EM and commodities by six months and their peak led the top in financial markets by about 15 months in January 2018. Besides, in 2012-‘13, the rise in the money and credit impulses did not do much to help EM stocks or industrial commodities prices. Hence, even if the money as well as credit and fiscal impulses bottom today, it could take several more months before the selloff in EM financial markets and commodities prices abates. Additionally, the ongoing regulatory tightening of banks and non-bank financial institutions will hinder these institutions' willingness and ability to extend credit, despite lower interest rates. We discussed in a recent report that both the effectiveness of the monetary transmission mechanism and the time lag between policy easing and a bottom in the business cycle are contingent on the money multiplier (creditors' willingness to lend, and borrowers' readiness to borrow) and the velocity of money (the marginal propensity to spend among households and companies). Growth in capital spending in general and construction in particular have ground to a halt (Chart I-13). Chart I-13China: Weak Capital Spending Not only has capital spending decelerated but household consumption has also slowed since early this year, as demonstrated in the top panel of Chart I-14. Chart I-14China: A Broad-Based Slowdown Finally, mainland imports are the main channel in terms of how China’s growth slowdown transmits to the rest of the world. Not surprisingly, EM share prices and industrial metals prices correlate extremely well with the import component of Chinese manufacturing PMI (Chart I-15). Chart I-15China's Imports And EM And Commodities Bottom Line: The slowdown in China is broad-based, and our proxies for marginal propensity to spend by households and companies both point to further weakness (Chart I-14, middle and bottom panels). Constraints And Chinese Policymakers’ Dilemma Given the ongoing slowdown in the economy, why are Chinese policymakers not rushing to the rescue with another round of massive stimulus? First, policymakers in China realize that the stimulus measures of 2009-‘10, 2012-‘13 and 2015-‘16 led to massive misallocations of capital and fostered both inefficiencies and speculative excesses in many parts of the economy – the property markets being among the main culprits. Indeed, policymakers recognize that easy money does not foster productivity growth, which is critical to the long-term prosperity of any nation. For China to grow and prosper in the long run, the economy’s addiction to easy financing should be curtailed. Second, policymakers are currently facing a dilemma. The real economy is saddled with enormous debt and is slowing. This warrants lower interest rates – probably justifying bringing down short-term rates close to zero. Yet, despite enforcing capital controls, it seems the exchange rate has been correlated with China’s interest rate differential with the U.S. since early 2010 (Chart I-16). Given the ongoing growth slowdown and declining return on capital in China, there are rising pressures for capital to exit the country. Notably, the PBoC’s foreign exchange reserves of $3 trillion are only equivalent to 10-14% of broad money supply (i.e., all deposits in the banking system) (Chart I-17). Chart I-16Chinese Currency And Interest Rates Chart I-17China: Foreign Currency Reserves Are Very Low Compared To Money Supply/Deposits The current interest rate differential is only 33 basis points. If the PBoC guides short-term rates lower and the Fed stays on hold or hikes a few more times, the spread will drop to zero or turn negative. Based on the past nine-year correlation, the narrowing interest rate spread suggests yuan depreciation. This will weigh on EM and probably even global risk assets. In a scenario where policymakers prioritize defending the yuan’s value, they may not be able to reduce borrowing costs and assist indebted companies and households. As a result, the downtrend in the real economy would likely worsen. Consequently, EM and global growth-sensitive assets will drop further. Given the constraints Chinese policymakers are facing, reducing interest rates and allowing the yuan to depreciate further is the least-bad outcome. Yet this will rattle Asian and EM currencies and risk assets. What About The Fed And Trade Wars? The Fed and EM: Fed policy and U.S. interest rates are relevant to EM, but they are of secondary importance. The primary driver of EM economies are their own domestic fundamentals as well as global trade – not just U.S. growth. Historically, the correlation between EM risk assets and the fed funds rate has been mixed, albeit more positive than negative (Chart I-18). On this chart, we have shaded the five periods over the past 38 years when EM stocks rallied despite a rising fed funds rate. Chart I-18The Fed And EM Share Prices: A Historical Perspective There were only two episodes when EMs crashed amid rising U.S. interest rates: the 1982 Latin American debt crisis and the 1994 Mexican Tequila crisis. Yet it is vital to emphasize that these crises occurred because of poor EM fundamentals – elevated foreign currency debt levels, negative terms-of-trade shocks, large current account deficits and pegged exchange rates. Dire EM fundamentals also prevailed before the Asian/EM crises of 1997-1998. However, these late-1990s crises occurred without much in the way of Fed tightening or rising U.S. bond yields. Trade Wars: China’s current growth slowdown has not originated from a decline in its exports. In fact, Chinese aggregate exports and those to the U.S. have been growing at a double-digit pace, largely due to the front running ahead of U.S. import tariffs. More importantly, China’s exports to the U.S. and EU account for 3.8% and 3.2% of its GDP, respectively (Chart I-19). Total exports amount to 20% of GDP, with almost two-thirds of that being shipments to developing economies. This compares with capital spending that makes up 42% of GDP and household consumption of 38% of GDP. Hence, capital expenditures and household spending are significantly larger than shipments to the U.S. Chart I-19Structure Of Chinese Economy There is little doubt that the U.S.-China confrontation has affected consumer and business sentiment in China. Nevertheless, the slowdown in China has - until recently - stemmed from domestic demand, not exports. Investment Recommendations It is difficult to forecast whether the current EM down leg will end with a bang or a whimper. Whatever it is, the near-term path of least resistance for EM is to the downside. “A bang” scenario – where financial conditions tighten substantially and for an extended period – would likely compel corporate and bank restructuring as well as structural reforms. Therefore, it is more likely to mark a structural bottom in EM financial markets. “A whimper” scenario would probably entail only moderate tightening in financial conditions. Thereby, it would not foster meaningful corporate restructuring and structural reforms. Hence, such a scenario might not mark a secular bottom in EM stocks and currencies. In turn, the EM cyclical outlook hinges on China’s business cycle. If and when Chinese policymakers reflate aggressively, the mainland business cycle will revive, producing a cyclical rally in EM risk assets. At the moment, Chinese policymakers are behind the curve. With respect to investment strategy, we continue to recommend: Downside risks to EM assets remain substantial. Stay put. EM stocks, credit and currencies will underperform their DM counterparts in the first half of 2019. The slowdown in China/EM will likely lead to global trade contraction. The latter is negative for global cyclicals yet bullish for the U.S. dollar. For dedicated EM equity portfolios, our overweights are: Brazil, Mexico, Chile, Colombia, Russia, central Europe, Korea and Thailand. Our underweights are: South Africa, Peru, Indonesia, India, the Philippines and Hong Kong stocks. We are neutral on the remaining bourses. In the currency space, we continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: ZAR, CLP, IDR, MYR and KRW. The latter is a play on RMB depreciation. The full list of our recommendation across EM equity, fixed-income, currency and credit markets is available on pages 14-15. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations